Vulture funds wary of overhang as distressed debt prices plummet

Distressed debt prices have been plummeting. But despite the availability of increasingly cheap targets, the growing committee of so-called vulture funds that invest in shaky bonds and loans is only dipping in an occasional talon.

By Dwight Cass, breakingviews.com

6:47AM BST 22 Oct 2008

That seems odd. After all, S&P Leveraged Commentary & Data's index of leveraged loans was at 70.4 on Monday. That's in line with the historical recovery rate on this type of loan in bankruptcy, which S&P pegs at 71. So leveraged loans would seem like a reasonably safe bet at that price.

But some of the vulture funds, especially the more opportunistic ones set up in the last year or so, like those backed by Lehman Brothers, BlackRock and Eaton Vance, originally had planned to snap up leveraged buyout-related debt that was trading at the time in the high 80s or even 90s.

Those that did put money into loans at those prices may be sitting on paper losses. To offset that, some funds have dipped into the market now and then to lower the average cost of their holdings, but they're generally not buying big chunks.

Other types of vultures, often those associated with private equity firms like Apollo or Cerberus, look to acquire controlling positions in companies through the bankruptcy process. They're sitting on the sidelines, waiting for borrowers to get closer to default before they swoop.

There's the chance prices could fall more, especially if investors think historical recovery rates don't reflect what they'll be able to claw back if the companies go bust. That's possible – the debt issued in the most recent boom was, on average, of lower credit quality than that issued in earlier cycles, and it was festooned with borrower-friendly innovations like covenant-lite terms that could impede lenders' recovery.

Also, while there is now only $40bn (£24bn) or so of US leveraged buyout-related loans stuck on bank balance sheets – a sixth of the peak last year – another overhang threatens. S&P LCD estimates that there's $50bn of loans held by investors like hedge funds and structured vehicles which they might be forced to sell.

That dam may already be cracking. The volume of loan portfolios sold in the first three weeks of October has already beaten the previous monthly record. Worries about the overhang are enough to make even hungry vultures think twice about pouncing now.